Educational Articles

Buying What China Wants: Profiting from the Giant’s Appetite

Mario Ferro
| May 09, 2011

It should come as no surprise to anyone that China’s economy has been on a tear for quite some time now. Indeed, annual growth of GDP has been averaging well into the double digits for three straight decades. Admittedly, this was off of a relatively low base, but the power of compounding has built up momentum, as it was only in the last few years that this country’s economy surpassed those of Germany and Japan, making it second only to that of the United States.

China’s middle class has been expanding rapidly, and now numbers well over 400 million. Just imagine a population bigger than that of the entire United States just making its presence known in the global consumption arena. The middle income populace there will want all the amenities that the West has enjoyed for decades, like cars, refrigerators, air conditioning, and TVs, as well as all the more recent gadgetry.

Although per capita wealth there is still well behind most fully developed nations, based on sheer size and demand, China is the largest emerging market and likely to become the biggest consumer market within a decade, or so. Indeed, between breakneck construction and industrial activity, and exponential growth in food and energy consumption, China is already the “World’s Largest” in several categories.

So how can the average investor profit from this trend? Well, fortunately, you don’t have to learn Mandarin and pore over Chinese annual reports (or even bother with China-based companies at all) in order to benefit from the increased spending by its government, businesses, and consumers. There are many companies located within the friendly confines of the United States that derive a large portion of their sales from China, often indirectly. Naturally, this is a broad category, but a quick look at some key areas should provide a sense of the scope of options available.

Driving Ambitions

It wasn’t very long ago that bicycles far outnumbered cars on China’s streets. Now, the Chinese buy more motor vehicles than anyone else. Just last year, China’s automobile production jumped 31%, to 18.1 million. This compares to about 11.6 million sold in the U.S. The interesting part is that, in 2000 China only built 2.1 million vehicles. The country also likes foreign cars. Auto imports jumped 93% last year, to 813,600 vehicles. Last year, General Motors (GM) sold more cars in China than in the U.S.

But the important thing to keep in mind is that China is huge, both in terms of size and population. According to the latest figures available, per capita vehicles in China are running around 200 per thousand. This compares to about 842 per thousand in the U.S. Stepping back to get a historical perspective, in terms of cars to people, China is now roughly where the U.S. was in the late 1920s. Just three years ago, it was comparable to the U.S. around the time of World War I (1914 – 1918).

Investing in individual car manufacturers can be a little iffy, as they are often prone to changing consumer tastes and managerial missteps. But if we do the math, a rising middle class the size of the entire U.S. population moving up to the luxury of automotive transport translates into an unprecedented potential increase in the demand for oil.

For decades, the U.S. was often scolded for its profligate ways in terms of energy use. While the rest of the world zipped around in gas-sipping econo-boxes, Americans sailed the wide-laned highways in boat-sized vehicles with miles-per-gallon ratings that often hovered in the single digits. But China is now the second largest consumer of crude oil in the world, even though its per capita consumption of energy is less than a third that of the U.S.

To be sure, China’s authorities are well aware of the country’s growing needs, and have long been rapidly working to secure the necessary resources to keep things moving. That is, they have been buying up oil companies, scrambling to secure long-term supply contracts, and building up reserves. Regarding the latter, by some reports, China is targeting 500 million barrels of strategic oil backup by decade’s end.

One example of this trend is illustrated in the recent moves by the Chinese oil giant, CNOOC LTD. Earlier this year it made a deal with Chesapeake Energy (CHK) buying positions in a number of oil and gas leases for $570 million, as well as earmarking another $700 million to help with drilling and other costs. Last year, CNOOC bought a one-third stake in Chesapeake’s Eagle Ford shale project, for nearly $1.1 billion.

In large part, integrated petroleum producers stand to gain from rising oil prices as China’s consumption swells. Among them, ConocoPhillips (COP), Chevron (CVX - Free Chevron Stock Report), Exxon Mobil (XOM - Free Exxon Mobil Stock Report) and Royal Dutch Shell plc (RDSA) are all quality names that should benefit from rising prices. As a kicker, they all generate respectable yields compared to the average payout. Imperial Oil (IMO) should also be considered. As Canada’s largest integrated oil company (and 70% owned by Exxon Mobil), it tends to do well as a “flight-to-safety” play whenever tensions rise up in the Middle East.

Metals And Mining

As the largest developing country, China is rapidly undergoing industrialization. As part of this process, it’s consuming a lot of metals. Copper is a particularly key commodity, as it’s used in a myriad of applications including residential and commercial building construction (plumbing and electrical power), infrastructure (power and telecom utilities), industrial machinery, and transportation. Overall, China consumes about 40% of the global supply of the red metal. Among the top selections in this space are Freeport-McMoRan Copper & Gold (FCX) and Southern Copper (SCCO).

Elsewhere, iron ore is also a hot item. It’s used to make steel, and, there again, China is the world’s largest consumer. The nation does make its own steel and mines its own ore, however it can’t produce enough of the latter. Key suppliers of this commodity include Rio Tinto (RIO), and BHP Billiton (BHP). BHP also represents a good selection as an all-around commodity provider. In addition to producing such necessities as crude oil, iron ore, nickel, copper, and coal, the company has the added advantage of being based in Australia, which has relatively close proximity to the Asian Continent. Naturally, the company has shown astronomical growth over the past decade, mirroring China’s increased appetite.

Picks and Shovels

In the days of the American gold rush, it was often observed that steadier profits could be made from providing services to miners and prospectors than from actually panning for the yellow metal. That is to say, a fairly reliable dollar could be made selling picks and shovels to the fortune seekers, versus the iffy prospects of finding a substantial ore deposit.

A modern-day equivalent can be found in the likes of Joy Global (JOYG). China consumes lots of raw materials, and the one thing such metals have in common is that they all need to be dug out of the ground. Joy Global makes nothing but mining machinery and equipment. With the rising global need for commodities, the company’s sales are up more than 10-fold over the past decade, and net profits have increased at an even faster pace, as an increased volume of business has helped improve margins markedly. Moreover, its prospects for further gains also appear healthy. As various commodities increase in use, and get harder to find, demand for Joy Global’s technically advanced equipment would likely rise in tandem.

For a broader customer base beyond metal miners, investors will want to take a look at Kennametal (KMT). While also serving the mining sector, this industrial toolmaker provides the equipment used in general engineering, transportation, energy, and other infrastructure manufacturing. We estimate Kennametal’s 2011 net profit will be quadruple what it was earning 10 years ago, and the stage appears set for continued growth in the years ahead.

Power To The People

With the fast increasing adaptation of Western world conveniences comes the commensurate need for electricity to keep all these appliances and gadgets humming. Despite the recent disaster in Japan, the most likely source to meet this anticipated rise in demand will be nuclear energy. Indeed, of the 65 nuclear power plants that were under construction before Japan’s recent crisis, 27 of them were located in China. Moreover, the country has another 50 in the planning stages. Adding these to the 13 it already has in operation, they would make China the world’s second-largest user of nuclear energy, behind the U.S., which has 104 plants. From an investment standpoint, this suggests a big potential demand for uranium, the key ingredient in keeping the plants churning out the voltage. Here, Cameco (CCJ), as the world’s largest uranium producer, stands to benefit directly.

Feed Me !

The Chinese population’s increasing wealth is prompting many to move from Consuming grain-based diets to eating more meats. However, one pound of beef requires 16 pounds of grain to produce. With all these mouths to feed, demand for agricultural products stands to rise in the years ahead. This means more fertilizers, herbicides, and pesticides will be needed to help increase crop yields. In this space, we like Monsanto (MON), whose products help growers produce higher yielding crops, Mosaic (MOS), which makes crop nutrients and animal feed products, and Potash (POT), one of the world’s largest fertilizer manufacturers.

Moreover, a lot of the products these companies manufacture are derived from petroleum (which circles back to our argument for rising oil demand), not to mention the need for gasoline and diesel in the equipment used to harvest, process, and ship food.

And while we’re on the topic of eating, it’s also worth noting that the fast food concept is spreading in China. America’s own KFC, for example, is the country’s largest fast food chain and the fastest growing, as well. A strong candidate to benefit from this trend is Yum Brands! (YUM), which owns KFC, Pizza Hut, and Taco Bell. It has been adding thousands of new stores, mostly in China, which already accounts for 40% of its global revenues.

So, to sum up, here you have a budding economic superpower, building up roads, railways, and entire cities. In the meantime, a vast portion of its population is moving from poverty level subsistence to middle class consumerism; going from eating rice to eating steak; from riding bikes to driving BMWs; from living in rural shacks to urban high rise apartments. And not only are they doing it at a faster pace than in developed countries, it’s happening in very large numbers.

Though we have only scratched the surface here, it’s clear that there are many ways to play this angle. None of these is necessarily a slam-dunk guaranteed winner, however. Also, should such stocks not be considered a viable short-term plays. Rather, these investment opportunities are based on established, long-term, fundamental themes that will likely take years to fully play out as China advances toward its full potential. As such, positions should be built up gradually, with an eye toward maintaining them for the decade ahead.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.